According to the Efficient Market Hypothesis (EMH), it is pointless to look for undervalued stocks or try to predict trends in the market, since an investor could simply choose stocks at random and do as well. According to most proponents of this theory, the stock market is presumed to follow a random walk much like that followed by microscopic particles suspended in fluid. These objects move about in a way which may look purposeful, but in fact it is simply the random forces of molecular bombardment at work. Similarly, though the market may look as if it contains meaningful patterns, these are in fact simply the random path traced by the stock price. The human mind is adept at finding patterns, and, as the EMH crowd likes to point out, it will do so even when the behavior is actually completely determined by chance. The essential idea that financial markets follow such a ‘Random Walk’ was first proposed by Louis Bachelier around 1900 when he successfully defended his Theorie de la Speculation at the Sorbonne. This was probably the first work which would fall under the rubric of what we now call mathematical finance. In it he stated that the market collectively holds all of the relevant information which is fully reflected in the price. Logically enough he reasoned that “if the market judged otherwise, it would quote not this price, but another price higher or lower.” In Bachelier’s view, stock prices would only move when the market revised its view of the value of the asset. He believed that at any point in time the market’s likelihood of increasing or decreasing was independent of any past behavior, effectively being jostled by extrinsic forces which could be considered random.

Figure 1 Simulated Stock Chart Heads/Tails method

A later theorist, by the name of Alfred Cowles, had a personal interest in the stock market and followed a number of forecasting publications in an effort to improve his investment performance. Eventually he began to wonder if it was really worth all the money to do so. This impelled him to do a thorough analysis of existing publications. By analyzing the track records of 24 of them he concluded, in a 1933 Econometrica article that “the average forecasting agency fell [below] the average of all performances achievable by pure chance”. Clearly, given this evidence, it seems the investor would have been better advised to hold a basket of stocks representing the market as a whole. In 1944 he published an even more ambitious study analyzing the forcasts of more than 6000 “experts” over a 15 year period, he again failed to discover any “evidence of ability to predict successfully the future course of the stock market.” An even more sceptical assessment was made by Paul Samuelson who concluded in a 1974 article that “a respect for the evidence compels me to incline toward the hypothesis that most portfolio managers should go out of business -- take up plumbing, teach Greek, or help produce the annual GDP by serving as corporate executives” From Journal of Portfolio Management (Fall, 1974).